Why Companies are Investing More in Services and Software than Products

by Barry Jaruzelski

Since the release of its first polished-steel plow way back in 1837, John Deere has provided the heavy machinery to prep, plant and harvest crops. Over the years, it has evolved into a true American icon. And its green and yellow tractors are undoubtedly the first thing many people associate with the John Deere brand.

Until recently, the company’s research and development (R&D) spending mirrored this product-centric focus. However, today’s John Deere has evolved far beyond the production of physical equipment. As the needs of their core customer evolve, the company is not only providing high-end machinery; it’s also developing the advanced sensors and software needed to service the modern farmer.

The sheer breadth of what this software can do to remove the guess-work from farming is compelling. It analyzes the density and moisture of soil to optimize the planting process. It enables machines to bury different seeds at the precise depths and spacing required by each distinct crop to flourish. It captures data summarizing exactly what is planted in each part of a given field, at any given time.

These innovations are not fortunate circumstance. They are the result of a conscientious shift in the company’s R&D resources. And when it comes to this shift, Deere is by no means alone.

The brand is just one of the world’s largest corporate innovators in the midst of a major transformational journey. It’s a journey that is shifting substantial R&D investment away from inventing, perfecting and selling physical products, and toward developing software to enhance those products – as well as services to further extend a company’s marketplace offerings.

The Global Innovation 1000 study (conducted by Strategy&, PwC’s strategy consulting business) offers an annual look at innovation trends and spending at the world’s 1,000 largest publicly listed corporate R&D spenders. The research examines the R&D footprint of these organizations to understand how much they are spending, on what and how overall R&D spend has shifted.

Since 2010, the average relative allocation of R&D spending on product-based offerings continues to decline. At the same time, the relative percentage of R&D spending earmarked for service and software offerings has continued to grow.

Today, R&D investment in product-based offerings still makes up the greatest percentage of corporate R&D portfolios. However, combined investment in service and software offering offerings accounts for 59 percent of R&D spending, and R&D spending for service offerings is on track to overtake R&D spending on products within the next few years. A significant shift that marks a fundamental change to the way these companies operate.

What’s driving such a transformational shift in R&D spend? Among the companies polled, three answers rose to the top. First, there is the need to stay competitive. Second, these organizations are making a push to grow revenue. And third, they need to keep pace with evolving customer expectations.

As was the case for Deere among its core agriculture audience, customers in every sector are expecting products and platforms to be more interconnected – and they want services to help them manage key devices and workflows. Companies must understand and closely monitor -if not predict- this dynamic and adjust R&D spend accordingly.

What’s Driving Such a Significant Shift in Resources?

The automotive industry provides another clear example of this shift. Years ago a good car needed just four elements: it had to run, turn, stop and have a decent design.

That’s not enough in today’s market. Customers expect cars to do so much more. This includes being “connected,” with integrated software and services ranging from navigation features to subscription music services and even autopilot modes.

No matter the industry, competitors are upping the game when it comes to introducing intelligence into their products and bundling software and services around traditional offerings. This is true whether the product in question is a car, a tractor, a washing machine or a refrigerator.

Companies that changed their R&D mix earlier and more aggressively are reaping dividends in faster relative revenue growth. Those currently allocating 25 percent more of R&D budgets to software offerings compared to key competitors report that revenues are growing significantly faster than those of competitors allocating less.

The shift to software and services is also impacting human capital and hiring plans. More R&D spending for software and services offerings means a need for more data and software engineers – and fewer systems, mechanical and electric engineers.

Among companies that employ electrical engineers, those reporting this category as their top engineering specialty can be expected to fall by 35 percent between 2010 and 2020. In 2010, only eight percent of companies said data engineers represented their largest group of engineers. This number is expected to double to 16 percent by 2020.

The shift in R&D spend captured in the Global Innovation 1000 represents a dramatic change in how corporations are allocating their dollars. While companies have talked about digitization and the rise of services for some time, this data shows organizations are now putting their money where their mouth is. And these investments are becoming increasingly tangible.

Today’s business leaders must develop a deep understanding of how this shift is affecting their businesses and industry. Imagine how a software startup might enter a given market. Consider which products or services are at risk as software becomes more powerful and pervasive. Successful leaders will ensure their innovation operating models are tightly aligned with new software and service offerings. Traditional R&D approaches remain valid, but more innovative approaches such as open innovation models, design thinking, agile methodologies, co-creation, and in-company incubators are increasingly important as portfolios change.

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Barry Jaruzelski is a Senior Partner at Strategy&, PwC’s strategy consulting business. He created the Global Innovation 1000 study in 2005 and is the author of this year’s report. He works with high-tech and industrial clients on corporate and product strategy and the transformation of core innovation processes.